The empires strike back

Satish Jindel, the president of transport consultancy SJ Consulting, had a conversation recently with one of his clients, a large retailer. According to Jindel, the retailer, which spends millions of dollars a year with FedEx Corp., complained that its rep wasn't keen on handling more of its parcel volumes.

Jindel, whose street cred frees him to administer tough love when deemed appropriate, told the retailer he wasn't surprised by the rep's reaction. "It's to be expected when retailers want parcel carriers to deliver to residences at unprofitable pricing just because they've spoiled consumers with free shipping," he said in a phone interview. Retailers, Jindel added, "can't expect FedEx to subsidize free shipping. They have to come up with creative ways to recover that cost."

So far, retailers have been about as creative as a sledgehammer. Caught between offering a supposedly "free" perk and still having to pay parcel carriers for their services, retailers have forced lower rates down their vendors' throats. However, Memphis, Tenn.-based FedEx and its chief rival, Atlanta-based UPS Inc., have had enough. They recognize it is impossible to turn their backs on business-to-consumer (B2C) volumes given their growing relevance (see Exhibit 1), and they are reconfiguring their networks to handle the business more cost-effectively. At the same time, though, the giants are signaling to retailers that they should begin accepting compensatory rates, or they should find another carrier.

MANY PACKAGES, NO PROFITS

Frederick W. Smith, FedEx's founder, chairman, and CEO, spoke bluntly about the profitability problem last December during the company's quarterly analyst call, acknowledging that there are e-commerce shipments it doesn't make any money on. T. Michael Glenn, FedEx's number-two executive until he retired at the end of 2016, said on the call that FedEx had "discontinued relations with a few customers" during the peak holiday season because their shipping profiles didn't align with the company's objectives of volume expansion and yield improvement.

Steve Gaut, UPS's chief spokesman, said in an e-mail accompanying its fourth-quarter results on Jan. 31 that the company must be "appropriately compensated" for the costs of expanding its physical and IT networks. At UPS, where B2C traffic in 2018 is expected to exceed business-to-business (B2B) volumes for the first time ever, 2017 capital expenditures will total $4 billion, up more than 30 percent from 2016 levels.

UPS is spending hundreds of millions of dollars to automate its "Tier 1" U.S. hubs that today handle a little more than half its domestic volume. The modernization should improve network productivity by up to 25 percent when the work is done sometime in 2019, according to Rob Martinez, president and CEO of Shipware LLC, a consultancy. This will allow UPS to route up to 60 percent of its total U.S. ground volumes through Tier 1 hubs, Martinez said.

FedEx Ground, the ground parcel unit that handles the bulk of FedEx's e-commerce deliveries, has added four major U.S. hubs and 19 automated stations in the past year alone, a 10 million-square-foot expansion. Smith called the pace of the build-out "one of the most remarkable things I've seen in my career."
However, massive investments will take a bite out of the carriers' revenues if the traffic mix isn't optimal. UPS's fourth-quarter revenue came in lighter than expected, in part because more customers used its cheaper "SurePost" service, where shipments are tendered to the U.S. Postal Service (USPS) for last-mile delivery, rather than moving solely through the UPS network, where the company could charge more. Wall Street proceeded to punish UPS's share price in the short run; from Jan. 31 through Feb. 2, the price of UPS's shares fell about $11 a share. FedEx shares fell about half that amount. (Both companies' shares have rebounded as of Feb. 10, the day this story was filed.)

At UPS, domestic B2C operating margins have ranged between 11.6 percent and 14.2 percent from the start of 2013 through the fourth quarter of 2016, according to SJ data. However, B2C margin growth has been compressed, albeit slightly, over that time. From the end of 2013 through the end of last year, domestic margins have fallen by 0.6 percent, SJ said. (See Exhibit 2.)

Retailers should take heed of the carriers' warnings about price adjustments. First off, there aren't many alternatives. USPS offers low prices and abundant last-mile capacity, but Smith on the analyst call argued that as a primarily last-mile carrier, USPS doesn't have the capabilities to deliver the so-called "upstream" services to parcel shippers and their customers. Amazon.com Inc., the Seattle-based e-tailer, is building out a transport and logistics network to fulfill orders placed on its website as well as those of third-party merchants using Amazon's services. Still, for retailers already competing with Amazon, using its delivery services would be akin to sleeping with the enemy.

If history is any guide, UPS and FedEx will find ways to surmount the e-commerce challenge. They raise their published rates annually, though they often agree to givebacks in return for large volumes. They have squeezed retailers in recent years by charging more for shipments that fail to meet certain dimensional parameters, and they continually impose an array of "accessorial" charges, fees for services beyond the basic delivery.

The carriers also laid down the law this past peak season, putting retailers on notice that the rules of the game had changed. Both adjusted their time-definite express delivery commitments during the critical final week before Christmas, directing drivers to deliver by the end of a committed day rather than by a specific time, according to SJ. In addition, FedEx Ground suspended its ground service guarantees for the entire peak season, while UPS did the same for Cyber Week (the week after Thanksgiving) and Christmas week, according to the firm. The adjustments to the delivery guarantees were designed to blunt the cost impact of residential delivery spikes rather than to maintain profitability by levying additional charges, SJ said.

Perhaps most significant, both are working to generate sufficient e-commerce delivery densities to reduce costs and capture more of the last-mile e-commerce traffic that they have historically tendered to USPS. The companies have operational alliances with USPS where residential packages are inducted deep into the postal network for last-mile delivery by postal carriers. USPS prices the service cheaply because it is already required by law to serve every U.S. address and can pick up or drop off parcels along the way. Though the model is popular with FedEx and UPS customers, the carriers don't generate much revenue from it and have to share what they take in with USPS.

FedEx is also consolidating shipments moving in its FedEx Ground, FedEx Home Delivery, and "SmartPost" service (FedEx's joint service with USPS) in a bid to boost efficiency. UPS, meanwhile, has created about 8,000 U.S. "access points," commercial establishments in residential neighborhoods where packages are dropped off for customers to pick up. Customers using the company's "My Choice" service can redirect a package to a convenient dropoff location. The strategy benefits UPS by consolidating multiple residential stops into one commercial stop, which optimizes UPS's network and minimizes costly "not at home" delivery attempts, said Martinez of Shipware. In addition, UPS has expanded its "Synchronized Delivery Solutions" capabilities, creating what Martinez calls "synthetic density" to speed up or slow down package deliveries so multiple packages get delivered at the same time.

The strategy of diverting last-mile deliveries into the carriers' own systems appears to be paying off, at least at UPS; its drivers now deliver about 35 percent of packages moving under its postal product rather than letting USPS do it. FedEx is nowhere near that level. However, few would bet against the company should it decide to follow the same course.

USPS, for its part, is concerned. In a Feb. 9 government filing, it acknowledged that the growth of that business—known in the postal world as "Parcel Select"—could be jeopardized if three of its biggest customers continue building out rival networks. USPS didn't identify the carriers, but it's clear that they are FedEx, UPS, and Amazon.

There's no question FedEx and UPS can pull multiple levers to get ahead of the e-commerce tsunami. However, they may still find it tough going unless they can convince retailers that they can't constantly demand lower prices just because they've made service commitments to consumers that they may now regret. "Bending the cost curve isn't just about density, but revenue per stop," Martinez said. "We see both carriers walking away if margins are forced too low." For retailers and other B2C shippers, that may require building a bit more cushion into their parcel delivery budgets.

We could all use some positive news and thankfully we have some for you: Many signs are showing that the freight markets are starting to recover.
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